COLUMN-What if the market has it right?: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

July 8 (Reuters) - The past 15 years of bubbles and busts notwithstanding, sometimes it may be best to just assume financial markets have got it right.

The central problem facing investors today is how to reconcile patchy and uneven growth in the economy with very full valuations for stocks and other risky assets.

What has been a constant tension over the past five years, during which U.S. stocks have more than doubled, was highlighted yet again last week when decent but not outstanding U.S. jobs figures (wage growth for example was poor) prompted investors to underwrite yet another stock market run to record territory.

In trying to figure out why financial markets are doing so well and risk is so well bid, there are two broad competing theories.

The first explanation is that financial markets are ahead of the curve. In this reading a stronger recovery which will justify rich valuations is just around the corner. If true, companies will see revenues jump along with overall economic growth, and margins with them, prompting a new round of investment in capacity and allowing for the vast majority of recently made risky loans to be repaid.

The second theory is that, far from being right, markets are being manipulated by central banks seeking to goose slow growth. Markets, therefore, are wrong, as they were in 1999 and 2006, but may be held aloft so long as policymakers still see a benefit in keeping the party going.

Bill Gross, the so-called bond king of asset manager Pimco, has a third theory, closely related to the second but different in important respects: that markets are right to be priced as they are, not because policy is going to work, as we with a pre-crisis mindset would think of it, but because, in effect, it will not.

Under this theory, which Gross calls the New Neutral, and which he has backed, according to a Bloomberg story, with an investment of $200 million of his own funds, markets are doing nothing more than mechanically calculating the value of future flows of income based on the belief that growth and interest rates will be capped at levels far lower than we assume.

“In a highly levered world, the real rate of interest has been and must remain reduced more than growth in order to keep our financed-based economy functioning,” Gross wrote last week in a note to clients.

LOOKING FOR NEUTRAL

At issue is the ‘neutral’ policy rate set by the Fed, a concept denoting the correct federal funds rate to be neither stimulative nor dampening to growth and inflation.

The very real possibility is that our reliance on adding new debt as a means of stimulating economic growth has left us with diminishing returns from both new borrowing and falling interest rates. That sensitivity to higher rates means that the economy requires a lower rate of interest than was usual 25 years ago in order to remain in balance.

Rather than the 1.75 percent fed funds rate which central bankers assume we will return to when things return to the status quo, we may only be able to handle something a lot closer to zero.

Financial markets attempt to place a value on the future stream of income represented by a security, such as the interest rate on a loan or bond or the dividends and capital gains expected of a stock. That’s driven, in part, by current interest rates and also expectations of where rates will settle in the future. The higher future rates are expected to be, the lower the value of those future cash flows, and vice versa.

So, that leaves open the possibility, as argued by Gross, that current valuations and bond prices make a lot more sense than those of us with our heads stuck in the 1980s and early 1990s assume.

Growth won’t accelerate and the Fed won’t be able to jump rates back to historic norms for quite some time. That leaves current stocks and bonds looking a lot more sensibly priced, if not with a lot of headroom for future strong appreciation.

Even if you accept the New Normal thesis, there are huge open questions. For one thing the very highly leveraged nature of the economy leaves it vulnerable to future shocks from whatever direction. Stocks priced for low growth and low rates will look terribly expensive and risky if that turns into negative growth and low rates.

Financial markets, in other words, may well have it about right now but still be a good deal riskier than they've usually been, even taking into account the last 15 crazy years. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft) (Editing by James Dalgleish)